Finding value in fixed income: How to navigate between low yields, higher rates and risk
Written in partnership with globeadvisor.ca.
Date: November 8, 2017
Original author: David Israelson
Over the past two to three decades, Canadian bond investments have been supported by a general downward trend in interest rates. Today, with interest rates low, investors may struggle to receive the same level of reward for the risks they take on.
"Value in an investment is a combination of price and quality," notes Kathrin Forrest, portfolio manager at Sun Life Global Investments in Toronto. "In fixed-income products, price is reflected in yields and quality is reflected in measures such as credit, concentration and liquidity risk. It comes down to how you're compensated for the risk you're taking on."
Add in potentially rising interest rates, and the investment environment for Canadian bonds is anything but straightforward. This is because as rates rise, bond prices fall; when rates fall, the value of bonds issued earlier at higher rates goes up.
In September, the Bank of Canada hiked its benchmark lending rate by 25 basis points to 1 per cent, its second rate hike in less than two months. The bank has left the door open to additional increases, depending on how the economy performs.
"The Bank [of Canada] raising its rates certainly affects short term fixed-income yields, but it doesn't necessarily mean that longer-term rates will go up as well," says Ms. Forrest. "While shorter term interest rates are largely driven by monetary policy, longer term interest rates reflect a range of other factors, including inflation expectations, demographics and technology."
In fact, as shorter term bond performance has been held back by recent interest rate hikes, longer term bonds have generated relatively favourable returns year to date.
The situation right now is a rather unnerving combination of higher-than-average interest rate risk in the broader bond market and lower overall credit quality. "You're faced with higher interest rate sensitivity, lower yields and greater credit risk," Ms. Forrest says.
In this environment, there's no single solution for the fixed-income investor.
"You need to target your approach to your specific needs, objectives and constraints. Depending on what you're looking for, fixed income can provide diversification, generate income in your portfolio, offer downside protection or liquidity," says Ms. Forrest.
It can be tempting for fixed-income investors to focus on the yield, but they should keep in mind that a higher yield is really compensating for additional risks that the investor is taking on, whether it's a risk of unexpected changes in interest rates, liquidity risk (the bond may be hard to sell) or credit risk (bonds with more credit risk might default).
"In the end, there's no free lunch here," says Ms. Forrest.
When rates are rising, we often see investors look for shorter dated maturities as they expect them to be less affected by rising interest rates, suggests Darren Coleman, author of Recalculating, a new book on financial advice, and senior vice-president of Coleman Wealth, Raymond James Ltd. in Toronto.
Mr. Coleman notes that some investors look for bonds and mortgage products that have a floating rate because these products generally see their interest rates move higher as the Bank of Canada raises rates.
"The key is that interest rates will always fluctuate, and there is no one fixed-income product that is right for all investors and all seasons," he adds.
It's important to note that in the context of shifting policy, the past is not always an accurate guide to the future, says Ms. Forrest. This suggests that now is a good time to be more deliberate with your fixed-income investments. In particular, investors may want to consider active management — portfolios that are managed so they seek alpha (above-market returns) while also meeting other objectives, such as reducing risk. The opportunity to earn additional returns, or manage risks, becomes much more important in a market environment that's challenged.
"If you want to generate stronger returns and meet your objectives, I believe you have to play not just strong offence but also defence," she says.
"It's tempting to reach, but you need to be careful that you don't stretch beyond your own risk profile. Be consistent with your overall objectives and strengths."